FORTUNE MAGAZINE Value Driven by Geoff Colvin

The government's new definition of rich

President Obama's tax plan won't help balance the budget, and it may hurt the upper middle class.

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By Geoff Colvin, senior editor at large

(Fortune Magazine) -- Are you rich? If you make $250,000 a year, President Obama and Gov. David Paterson of New York think you are. The SEC disagrees. It tells financial firms that a high-net-worth individual is someone with at least $750,000 parked at a particular institution or someone the firm "reasonably believes" to have a net worth exceeding $1.5 million.

The reason this debate matters is that federal and state governments are looking at the worst deficits ever seen. In their desperate search for funds, they are going to tax some subset of the wealthy. Let's hope they train their cross hairs where they do the least damage.

When President Obama said he would raise taxes on the wealthy, he set the increases to start at an income of about $250,000. Gov. Paterson recently worked out a rise in New York's state income tax that takes effect at the same level. If all that those politicians mean by "rich" is the small portion of the population at the top of the economic heap, then households making over $250,000 is a fair definition: Only about 5% of U.S. households have annual incomes over $200,000.

The flaw in that definition of rich is that plenty of families making $250,000 a year don't feel rich. They probably see themselves as upper middle class, especially if they live in blue-state coastal cities and suburbs. An income of $250,000 is a lot richer in Abilene, Texas, than in New York's Nassau County, where it takes $430,000 to enjoy a similar quality of life, according to bankrate.com. So let's call them the "working rich."

What's troubling about raising the tax burden on the working rich is that this group already pays proportionately more tax than the super-rich. In addition, the working rich aren't as adept at sheltering their wealth from the tax man through deferred-compensation schemes or other loopholes.

In 2006, the most recent year for which information is available, the average tax rate for the working rich was 22.8% - that is, after all was said and done, they ended up paying 22.8% of their adjusted gross income in income tax. The floor for being in the top 1% was an income of $388,806. That same year the average tax rate paid by the super-rich - the 400 filers with the highest incomes - was only 17.2%.

What is possibly more galling than the easier ride of the super-rich is that raising taxes probably won't accomplish much when it comes to getting us out of these troubled times. Consider a couple of harsh realities:

Soaking the rich doesn't stimulate the economy. It only changes who is doing the spending - the government or private citizens.

Soaking the rich doesn't even seem to increase tax revenues. The top marginal tax rate has fluctuated wildly over the past 50 years, from 91% to 28%; it's now 35%. But individual tax revenue as a percent of GDP hasn't varied much at all - it hovers at about 8% - and its variations don't correlate with the top tax rate. The reasons are many, but the bottom line is that as government deficits soar to unimagined levels, taxing the rich isn't likely to yield nearly as much as governments are hoping for, and it may not yield anything when the numbers are all totaled.

The best alternative is to rein in spending. If we are going to create record deficits, it would have been better to do it by cutting taxes than by jacking up spending, but that battle is over. Now let's be sure not to increase the stimulus, as Obama has suggested we might, and not let taxes rise in 2011 as they're scheduled to do. Most important, the Federal Reserve needs to keep interest rates low, which research shows is the main factor that ends recessions.

There is one thing that soaking the rich will do effectively, and that's redistribute wealth. Obama's new budget would increase federal payments to low- and some middle-income Americans through increases in the Earned Income Tax Credit, the Child Tax Credit, and other programs. Candidate Obama was quite clear that he intended to do that, so he can rightly claim that the voters gave him a mandate for it. Let's just understand that reslicing the pie to give the rich a smaller piece doesn't make the pie any bigger - and won't get us out of the recession any faster.

REPORTER ASSOCIATE Alyssa Abkowitz contributed to this article. To top of page

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